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Will Microsoft’s Deals with China Telecom and JD.com Boost Xbox One Sales?

Microsoft (NASDAQ: MSFT) just signed two deals -- one with China Telecom (NYSE: CHL) and another with e-commerce site JD.com (NASDAQ: JD) -- to launch the Xbox One in China, which recently lifted a 14-year ban on gaming consoles.

Source: Microsoft.

China Telecom, the third largest telecommunications company in the country, will start selling the Xbox One starting in September through an exclusive contract to its 30 million broadband customers, according to Reuters. China Telecom has not officially set the price yet.

JD.com, the country's second largest e-commerce company by market share, started accepting pre-orders for the Xbox One from July 28 to July 30. The pre-orders will be accepted through Tencent Holdings' mobile social networks Mobile QQ and WeChat (Weixin in China). Tencent currently holds a 17.6% stake in JD.com, which competes directly with Alibaba's Tmall.

Last September, Microsoft entered the Chinese market through a joint venture with Chinese set-top box maker BesTV New Media to manufacture the consoles in Shanghai's Free Trade Zone. Sony (NYSE: SNE) signed a similar PS4 manufacturing agreement with Shanghai Oriental Pearl Culture Development (OPCD). Both BesTV and Shanghai OPCD are subsidiaries of the Shanghai Media Group.

Will Microsoft's trio of Chinese partnerships help it gain ground against Sony's PS4 and Nintendo's (NASDAQOTH: NTDOY) Wii U, which are both outselling the Xbox One worldwide?

A massive market with massive challengesMicrosoft, Sony, and Nintendo all hope that the lifted ban on gaming consoles will turn PC gamers into console ones.

It's certainly a massive market -- Niko Partners estimates that the Chinese PC online games market will nearly double from $11.9 billion in 2013 to $23.4 billion in 2018. By comparison, Gartner forecasts that the worldwide console market will be worth $55 billion by the end of 2015. There are an estimated 600 million gamers in China -- nearly double the population of the U.S.

However, it's not going to be easy to convert PC gamers to the Xbox One overnight. In a previous article, I noted that a survey from GameSpot GameTrax revealed that only 8% of early Xbox One owners and 10% of PS4 owners came from PCs. Meanwhile, the Chinese PC market is facing a threat from domestically made mobile games, which are also a disruptive threat to console adoption.

Meanwhile, the "government ban" was actually rarely enforced. There were plenty of gray markets and online stores in China that sold North American and Japanese consoles. In fact, Alibaba's Taobao currently sells imported Xbox Ones for 3,100 to 3,700 RMB ($500 to $600). This means that most people who wanted an Xbox One, PS4, or Wii U probably already bought one.

Microsoft knows the Xbox One will be a tough sellMicrosoft isn't oblivious to these challenges, and is tossing in a lot of extras for early adopters in China. A recent picture on Weibo (China's equivalent of Twitter) revealed that the Xbox One "limited edition" bundle will cost 3,499 RMB ($565).

Chinese ad for the Xbox One. Source: Weibo

The bundle includes the console, one controller, the Kinect, a 100 RMB ($16) JD.com coupon, another 100 RMB coupon for a second controller, a "gift pack" worth up to 1,000 RMB ($160), and three "blockbuster" games. The contents of the gift pack and three games are unknown, but it's a massive bundle that actually makes the console and controller cheaper than the $399 Kinect-less version in North America.

However, the deal with China Telecom could further reduce the console's price, which can be subsidized with wireless and broadband plans. This could help Microsoft gain an early foothold with Chinese households who are signing up for new Internet plans or renewing their contracts.

Another advantage that Microsoft has over Sony and Nintendo in China is that it is an American brand, not a Japanese one. Due to decades of anti-Japanese sentiment and recent riots over the sovereignty of the Diaoyu/Senkaku Islands, many Chinese consumers intentionally avoid Japanese brands. This can be seen in the auto market, where Volkswagen and General Motors dominate Japanese competitors as the largest foreign automakers in China.

Could piracy crush these console dreams?The other key problem is software piracy in China, which had a software piracy rate of 74% in 2013, according to BSA.

Since Microsoft will sell the Xbox One hardware at paper-thin margins or a loss in China, it generally takes a 30% cut of retail Xbox game sales to recoup its losses. But if Chinese customers hack the consoles and load up the hard drives with pirated games -- a routine service in gray markets -- higher console sales would cause Microsoft to lose money instead.

Microsoft fell into this trap before. Three years ago, former CEO Steve Ballmer complained that software revenue from China was only equivalent to 5% of U.S. revenue due to piracy, although PC sales from both countries were roughly the same.

The Foolish takeawayIn conclusion, Microsoft is clearly serious about launching a pre-emptive strike against Sony and Nintendo in the Chinese market. It knows that it has a better chance of succeeding in China than in Japan, which it doesn't plan to enter until September due to Sony and Nintendo's market dominance.

Looking ahead, Microsoft and BesTV will demonstrate the Chinese Xbox One at the ChinaJoy Expo in Shanghai from July 31 to August 3, which should give investors a better look at Microsoft's long-term plans for expanding into China.

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